Crash of all Crashes coming.

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The Bubble of all time is about to crash and its called the "BOND BUBBLE"

Will Dodd-Frank Help High Frequency Traders Crash The Bond Market Too?

On Wednesday September 29, 2010, 1:18 pm EDT

Lawmakers may have unintentionally opened the bond-market up to high frequency traders by passing controversial derivatives-clearing requirements as part of the Dodd-Frank financial reform bill.

The Blanche Lincoln-sponsored clearing-house requirements will force certain derivatives, including many credit default swaps (CDS) on corporate bonds, to be cleared by centralized clearing houses and traded on swaps exchanges. The hope is the this will make the market in derivatives more transparent and reduce counter-party risk.

Very little attention has been paid to the likely unintended consequences of this move. Let's begin with a simple observation: government intervention into established market processes always produces unknown and unintended consequences.

Regulations have to do this because they are taking a known process and replacing it with an unknown process. There's simply no way to do this in complex financial markets with the full knowledge of the outcome.

In the market for credit default swaps that evolved prior to Dodd-Frank, many swaps were done directly between two parties. Often one or both parties was a large broker-dealer. A hedge fund, for example, would approach a Wall Street firm like Goldman Sachs (NYSE: gs) to buy protection on the bonds of, say, Ford (NYSE: f).

Goldman would typically hedge its risk by approaching another broker-dealer and buying protection on those same bonds. The lack of pricing transparency in the markets often allowed the Goldmans of the world to get better pricing than smaller investors could on the same protection, allowing Goldman to pocket a bit of a profit on the spread between the swap it sold and the swap it bought.

Obviously, the lack of transparency means that customers who cannot broadly canvas the market are at a disadvantage to those that can.

Basically, big Wall Street firms were winners here. In fact, one of the reasons Wall Street moved so hard into the derivatives market in the last decade was that the bond market had become more transparent after the SEC approved a proposal by the National Association of Securities Deals to report corporate bond trades to an electronic system. This had the intended effect of improving investor confidence and reducing the information arbitrage profits of Wall Street firms.

It had the unintended consequence of moving much of the trading action into opaque derivatives.

Dodd-Frank's transfer of swap trading from over-the-counter to exchange trading and clearing will likely make the market more transparent. But this increased transparency will likely lure in hedge funds eager to exploit inefficiencies in the new system of trading.

Instead of exploiting opacity and employing informational arbitrage, the hedge funds will seek to exploit advantages of calculational speed, algorithmic adeptness, and computational sophistication to squeeze out profits in clearing house processed and exchange traded derivatives. In short, we're about to introduce high-frequency trading for derivatives.

How will this play out? It's not exactly clear. We know that high-frequency traders have been able to rise to a dominant role in the markets, thanks in large part to a regulatory push to break up the stock market oligopolies and limit the role of favoritism and front-running by specialists.

Markets are now more liquid, but they also appear to be more volatile. Many suspect high frequency trading contributed to the severity of the flash-crash, although exactly how is still open for debate.

But this should be reason for caution. We don't have a firm understanding of the role high frequency traders play in the equities markets. There's no way we can have an understanding of what will happen in the derivatives markets once these are open to them.

Let's imagine, however, what a flash crash might look like in the CDS market.

Let's say high-frequency traders have become liquidity suppliers to the market, buying and selling bond protection. The broker-dealers have stopped providing this liquidity, in part because their profits have been squeezed out of the market by the new transparency. One day, an event somewhere in the world triggers the algorithms of a few highly correlated HFT shops to start buying more protection on a wide variety of stocks.

This triggers other HFT programs to stop selling, which triggers more buying. Prices on CDS soar across the board. The clearing houses start demanding more collateral from everyone to reflect the higher prices, triggering a rush for cash by everyone participating in the market.

Meanwhile, the risk management operations of institutional investors detect the soaring CDS prices, which are read to signal that the bonds are about to become distressed. The corporate bond market sells off and even more buyers for CDS enter the market. The short-term credit markets freeze up as money market funds stop providing credit to what look like increasingly risky corporate borrowers.

And then the clearing house notices that some market participants aren't making good on the collateral calls, so it starts closing out their positions. Outsiders get wind of this and begin to doubt the solvency of the clearing house, triggering a run on the clearing house itself. With no one able to process trades through the perhaps insolvent clearing house, and all other alternatives have been declared illegal by Dodd-Frank, the credit markets seize up completely.

The next thing we know, we're all hearing about emergency meetings down on Maiden Lane, where bankers and regulators are putting together a plan to fend off the next Great Depression. The plan is elegant and its proponents are articulate and highly adroit at defending it against critics. It involves the transfer of risk from the private market participants to the taxpayers. It is, in short, another bailout.

Can we handle a flash crash in the bond market? Are we prepared for a freeze in derivative clearing? Has anyone even asked these questions?

Very little attention has been paid to the likely unintended consequences of this move. Let's begin with a simple observation: government intervention into established market processes always produces unknown and unintended consequences.

Regulations have to do this because they are taking a known process and replacing it with an unknown process. There's simply no way to do this in complex financial markets with the full knowledge of the outcome.

We do this every day with futures and options. There was a time when these derivatives also traded off exchanges. Before stocks traded on exchanges there was little public information available about the company one was investing in. You had to rely on word of mouth and faith in your own ability to get the knowledge you needed to invest wisely. Only the very well connected had this knowledge.

Now, due to government regulation, you can look at the financials of any publicly traded company anytime you want. You can say there are still accounting tricks, but which would you rather rely on? Do you want to go back to the days when the stock you just bought might be in a float of 2B or 200M? Who knows how much stock is outstanding? Maybe the EPS was good, maybe not, but you can't see the balance sheet and cash flow. Just take their word on it ...

People produce economic activity with unknown outcomes - chaos. Regulations exist to ensure fairness in the market through transparency, accountability and management of activity which can produce untoward damage to others.

The government is not some entity in space, like an alien on a cloud, ready to attack us. The government is what we call it when people agree together to make this chaos work for us all somehow, but without the necessity of a profit. It's what people do to make changes rather than make money. It's made of people. True, there is corruption in government. Also on Wall Street. Should we dismantle both?

The existence of corruption where there is power is not a reason to give up the ghost. It's a balance. It's rather ridiculous to suggest that regulation is the cause of ruination in the stock market and economy when history demonstrates repeatedly that the opposite is true. Regulations go away first, then corruption settles in. This is precisely what happened in the housing bubble and every other bubble back to the tulip craze in the 1600s. Oh, gold doesn't solve the problem of corruption, sorry, so this problem doesn't go away if you're on a gold standard. It never prevented bubbles in the past.